Lenders are once again pushing short-term adjustable rate mortgages, called ARMs, and homebuyers seem to be snapping them up. Does this mean we’re headed for another round of easy and dangerous lending practices?
Adjustable Rate Mortgage Trend & Consequences
According to CNBC, more people applied for ARMs last month than they have since October 2014. Mike Fratantoni, the Mortgage Brokers Association’s chief economist, explained the trend this way: “Homebuyers in a strong housing market are looking for ways to extend their purchasing power, and ARMs are one way to do that.”
That basically means that with home prices and interest rates rising, borrowers are having a harder time qualifying for homes. Short term, adjustable loans loans tend to offer lower interest rates than 30 years fixed mortgages, allowing homebuyers to qualify for more.
However, the problem with an adjustable rate mortgage is that the rate changes according to the index it’s tied to. If interest rates increase, so will payments. And that could be dangerous for some borrowers who are already at the threshold of affordability.
Greg McBride, chief financial analyst at Bankrate.com, told The Street, “If your timetable changes and you have an adjustable-rate loan, then you may want to reconsider.” He warned, “You don’t want to be in the position of facing rising monthly payments that squeeze your budget or jeopardize your ability to afford your own home.”
Chief economist at CoreLogic, Frank Nothaft, added his two cents and warning on the topic, observing, “With higher mortgage rates, lenders generally will respond by applying the flexibility in underwriting guidelines to make loans to harder-to-qualify borrowers. As this occurs, we should observe our index signaling a gradual increase in default risk.”
This scenario is exactly what happened last decade at this time in the market cycle. As we reach the top of a market cycles, home prices and interest rate rise – and housing becomes unaffordable. Lenders respond by making it easier to borrower, as they don’t want to see their pipelines dry up. Borrowers take the loans because they think home prices will rise forever and fear they’ll never have a chance to get into the market if they don’t buy now.
What they fail to realize is that market cycles repeat themselves. The expansion period of a market cycle is always followed by contraction, which leads to recession. During a recession, experienced investors who understand cycles jump in and buy all the bargains, which leads to recovery. Others start to notice the recovery – specifically the media – which then attracts the masses, which leads us back to expansion. It’s the most exciting to buy during the expansion phase IF you buy at the beginning of it.
Unfortunately, new investors come in at the end of the expansion phase because at this point, they see that others have made so much money. What they don’t realize is a correction is coming – and likely right around the corner. They end up buying at the peak of the cycle, just before the contraction begins.
If these new owners have taken on adjustable rate mortgages, and rates increase, they may have difficulty making payments. And they will be less interested in making those high payments if they arent’ seeing asset prices rise. If asset prices fall, then they have no incentive to make those payments… thus foreclosures increase.
Does this mean we’re headed for another massive housing crisis like 2008?
Fratantoni commented that, “The ARM share got as high as 35 percent pre-crisis,” and added that, “It is really unlikely it will get nearly as high now given new regulations, which effectively prohibit many types of ARMs that were prevalent then.”
Plus, approximately 30% of purchases over the past decade have been all cash or to investors with good credit and reserves. But that could change as home-buyers face the mounting issue of affordable housing, and lenders look for solutions to keep their businesses churning.
Perhaps there will be better solutions created this time around. I am currently at an event where I had the honor of sitting with the chief economist of Fannie Mae, Doug Duncan. I asked him if there was any discussion in Washington regarding increasing the number of loans investors can obtain. He said, “They are discussing it.” But don’t get too excited. He also said it could take a few years to implement any changes.
Now some people think that allowing people to finance more investment properties could be dangerous. However, if those investors are putting down 25%, have adequate reserves and experience, it could be a better solution than offering first time homebuyers no-money down options and adjustable rate mortgages.
According to a report released last week by the New York Fed, 32.5 percent of Americans would have trouble coming up with $2,000 in a time of crisis, such as a medical emergency or car accident. Does it make sense for them to own a property that most likely will have some unexpected repair costs over time?
Zillow senior economist Aaron Terrazas wrote back in April 2015, almost exactly two years ago, that “deteriorating rental affordability is a pressing national issue.” He warned at the time that more than half of U.S. renters said they could not afford a home and did not expect to be able to in the future.
This means we’ll likely continue to see homeownership rates decline – we are now at a 50 year low. And that means more landlords will be needed to provide affordable rental housing until these future homeowners can increase their savings.
This offers an opportunity to people looking for steady cash flow from rental property. It also offers a strong opportunity for seller financing to help renters become buyers.
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